Would you lend money to the governor?

When you buy a Massachusetts general obligation municipal bond, that’s what you’re doing – lending money to Governor Deval Patrick and our other elected officials. Of course they promise to pay you back, with regular interest payments along the way. But will they, or those who follow them in office, be able to?

The growing uncertainty around the solvency of states is roiling the municipal bond market, sending tax-free yields above taxable yields for the first since the dark, crisis days of 2008. Investors are demanding this yield premium for state-backed bonds as compensation for perceived risk. The 10-year tax-free municipal bond yields 3.59%, more than the taxable 10-year Treasury’s 3.4%.

What’s going on? Blame the upheaval on the d-word – state default.

Many are quick to point out that state default just can’t happen. A bankruptcy filing is not a legal option for states. This is true. But as this NY Times article describes, Congress has quietly begun investigating the possibility of legalizing state default. It sure sounds like a long shot, however, remember how purely outrageous the General Motors bankruptcy talk sounded in 2008?

Meredith Whitney, who gained fame by predicting in October 2007 that Citigroup would have to cut its dividend (unthinkable!), has been circulating a report predicting federal bailouts of states before the end of 2011.

One can only speculate on how this will all play out. Trying to base investment decisions on the unknowable outcome of various states’ fiscal crises is a guessing game, not an investment strategy.

This mess points to the importance of another d-word – diversification. While it may be scary – or even irresponsible – to lend a large sum of money to any one governor, spreading that investment across many jurisdictions and maturities dilutes the exposure to problems in any single state. Low cost ETFs provide access to hundreds of bond issues via a single investment, and, we think, make it easier to ignore the elevated rhetoric and speculation surrounding state solvency.

So, would we lend money to Deval Patrick?  Yes, a tiny bit to him, and many tiny bits to many others.

What do you think about this issue?